Choice of Entity Considerations – Part I
1. Formalities of Existence
Of the major forms of business, C and S corporations have the most burdensome requirements regarding formalities of existence. These requirements reflect the fact that a corporation is a separate legal entity from its owners. A corporation must file articles of incorporation with the secretary of the state in the jurisdiction of organization. It must also adopt bylaws, elect a board of directors, hold organizational meetings, and keep minutes thereof. Although these are the general rules with regard to the formalities a corporation must observe, each state has its own incorporation requirements that must be examined and observed.
A general partnership usually has no formal registration requirements. It may be established informally without a written agreement. A limited partnership, as a creature of state statute, must observe certain formalities. In particular, a certificate of limited partnership must be filed with the secretary of the state of formation. In addition, the partnership must follow the organizational requirements imposed by that state. Similarly, a limited liability company must file with articles of organization a state, and must comply with state requirements that are a condition of its limited liability status.
2. Tax Aspects of Formation
When a C or an S corporation is formed, the owners generally contribute property or services to the entity in exchange for stock. If property is contributed, the owners do not recognize gain on receipt of the stock provided they are in control of the company. That is, if they own 80% or more of the voting power or 80% or more of all other classes of stock. If, however, the contributors receive something other than stock (i.e., cash), they must recognize gain in the amount of the nonqualifying property received. This rule also applies if the individual contributes property subject to debt (i.e., the transferor is treated as having received cash equal to the amount of the debt). An individual who contributes services in exchange for stock must generally recognize gain. However, the corporation may be able to deduct the compensation to the extent it is not treated as a capital expenditure.
The tax consequences of forming a partnership or a limited liability company taxed as a partnership are similar to those governing corporate formation. A contribution to the entity in exchange for an ownership interest is generally not a taxable event. However, the partnership nonrecognition rules are more liberal than the corporate rules in that there is no requirement that the owners be in “control” of the partnership after the contribution. If, however, a partner contributes encumbered property to a partnership, the receipt of such property is treated as a transfer of cash to the contributing owner and is likely to be treated as a partnership distribution equal to the amount of the debt. Specifically, the other owners’ share of the liability is deemed to be distributed to the contributing owner.
A partner (or LLC member) who contributes services in exchange for a partnership interest generally recognizes gain equal to the value of the interest received. However, if the partner receives only a right to future partnership profits as opposed to a capital interest, then no gain is recognized.
In part 2, we discuss Limited Liability of Owners, Taxation and Owner Compensation.